China Moves Forward With Further Bond Market Opening

China is revving up efforts to expand the accessibility of its $9 trillion bond market to global investors as it seeks to woo more foreign capital to counter capital outflows.

On the sidelines of the recently concluded National People’s Congress, Premier Li Keqiang said authorities are considering a trial program that will connect the mainland bond market with Hong Kong, allowing foreign investors to purchase mainland bonds from the coastal city.

Li’s remark is seen as the latest effort by Chinese authorities to open up the country’s bond market, which is the third-largest in the world after the U.S. and Japan. Last month, the country’s foreign exchange regulator announced a new policy to enable foreign bond investors to trade derivatives products in the country, offering them much-needed tools to hedge currency risk.

The continued efforts have paid off for China as two major global index providers have decided to add Chinese bonds to their global benchmarks. In early March, Bloomberg Barclays launched two new hybrid fixed income indexes that include China bonds, becoming the first major index provider to include yuan bonds in its global offerings. Citigroup followed suit, saying that it will embed China bonds into its bond market benchmark WGBI-Extended.

Another global index provider, JPMorgan Chase & Co. said it is evaluating the entry of China markets into its JPMorgan Global Emerging Market Bond Index.

Ma Jun, chief economist at the People’s Bank of China’s research bureau, said the inclusion indicated that the opening of China’s bond market was gaining recognition among international investors.

Foreign investor bondholding in China’s 63.7 trillion yuan ($9.23 trillion) bond market remains low. Official data show that by the end of February, 464 foreign institutions held about 870 billion yuan worth of bonds in China’s interbank market, or less than 1.4% of all Chinese bonds, although the amount has increased rapidly from the 400 billion yuan held by 182 investors in 2015.

China’s inclusion on global bond indexes provided by all three companies is expected to spur capital inflows of potentially $250 billion, according to Goldman Sachs.

But both Bloomberg Barclays and Citigroup have yet to add Chinese bonds to their most influential indexes. Bloomberg Barclays said the yuan-denominated bonds are not currently eligible for inclusion in its flagship Global Aggregate Index.

A Citigroup spokesperson told Caixin that the company will continue monitoring the Chinese bond market in the next few months to make sure it is qualified to be included in the other three government bond indexes in February 2018 — the Emerging Markets Government Bond Index, the Asian Government Bond Index and the Asia Pacific Government Bond Index. But Citigroup said it doesn’t plan to add China to its most tracked World Government Bond Index, which covers 23 markets.

A survey conducted by Deutsche Bank last year showed that despite global investors’ growing interest in China’s onshore bond market, major impediments to further foreign investment in China’s bond markets include the lack of reference provided by major indexes and risk hedging tools, as well as concerns about free capital flow amid China’s battle against capital flight.

China has made a lot of progress in opening its domestic bond market to foreign investors in recent years as policymakers push to modernize the domestic financial market and promote the international use of the yuan. In July 2015, the central bank gave the green light to central banks, multilateral financial institutions and sovereign wealth funds to invest in its interbank bond market. Access has been further expanded to all foreign institutional investors since February 2016.

Steps to open the bond market have accelerated this year as China seeks to boost capital inflow to help stabilize the yuan and buttress its dwindling foreign-exchange reserves. In late February, China’s foreign exchange regulator allowed overseas investors in its interbank bond market to trade derivatives for hedging currency risk, a crucial move to make the market more attractive to overseas investors against the backdrop of exchange rate fluctuations, analysts said.

Before this, investors had to resort to more expensive offshore foreign exchange hedging solutions.

But a significant increase in foreign investment will not be seen immediately as there are currently not enough mature derivatives tools available in the onshore market for foreign investors to manage risks, said Xie Tong, China head of debt capital markets at JPMorgan.

Li Minhong, general manager of bond investment in North Asia for Deutsche Bank, said, “We have seen that some problems foreign investors are concerned about have been solved gradually over the past half year. But it is just a start.”

Lingering Concerns

Several foreign institutions interviewed by Caixin said a major concern about expanding bond investment in China is that the country’s efforts to clamp down on capital flight may affect cross-border cash flows.

But JPMorgan’s Xie and Deutsche Bank’s Li both said there is no sign that control of ordinary capital outflow has been tightened.

Pan Gongsheng, head of the State Administration of Foreign Exchange (SAFE), at a February news conference dismissed fears that policymakers may revive across-the-board capital controls. “We will not close windows that are already open,” Pan said.

Regulators will enhance the scrutiny of forex transactions’ authenticity and regularity, intensify the crackdown on irregularities, and ensure the healthy development of forex markets, Pan said.

Guan Tao, a former official with SAFE and a senior researcher at a think tank called China Finance 40 Forum, said the mounting pressure from capital flight provides Chinese regulators with a good opportunity to reform foreign exchange policies to widen accessibility of the financial market to lure more money inflow.

The best way to encourage inflow is to reduce administrative interference, said Guan, saying regulators should adopt the “negative list” approach to largely liberalize the market, “as long as the market has demands, institutions have the ability (to meet the demands) and the supervision is in place.”

Guan said China’s progress in liberalizing the capital account requires coordination among different departments to improve the overall infrastructure of the financial market. His comment echoed that of the foreign exchange chief, who said China is working to improve arrangements of related regulations — legal, accounting, auditing, tax and credit rating — to encourage overseas institutions to issue onshore and to invest in the domestic market.